WACC - what is this indicator? Concept, formula, example, use and criticism of the concept

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

Today, all companies use borrowed resources to some extent. Thus, they function not only at the expense of their own funds, but also credit. For the use of the latter, the company is forced to pay a percentage. This means that the cost of equity is not equal to the discount rate. Therefore, another method is needed. WACC is one of the most popular ways to evaluate investment projects. It allows taking into account not only the interests of shareholders and creditors, but also taxes.

Example

So, we figured out that WACC is an indicator of the average return on investment costs. But how to calculate it and what does taxes have to do with it? Suppose a company is funded 60% by shareholders and 40% by creditors. For example, it has been calculated that the cost of owncapital should be 20%. And the company managed to get a loan at 15% per annum. If we approach the issue of calculating the weighted average equity capital from the point of view of logic and mathematics, then we will get 18%. But is everything so simple? Suppose a company has invested $1,000 in the project under consideration: 60% - shareholders, 40% - creditors. If the duration of the project is one year, then the after-tax cash flow will be $1,180. USA. A thousand dollars goes to pay off the main investment. And the remaining 180 dollars. The US should be distributed between shareholders and creditors. The latter will receive $60. And here the most interesting begins. Interest payments can be tax deductible. Therefore, the company will be able to return some of the money. If the tax rate is 25%, then that's $15. And this means that shareholders will receive not 120, but 135 dollars. USA. Therefore, we can conclude that the company could have earned less initially. And still it is impossible to satisfy the requests of both shareholders and creditors. It cannot be said that WACC is an indicator of the average return on sales, since it deals with the performance of the company as a whole. But it was he who would make it possible to make a much more accurate calculation.

Concept

As it was already possible to conclude from the above example, WACC is an indicator that allows to determine the required profitability of the project for creditors and investors. And it also takes into account taxes. In the previous example, it is not 18%, but 16.5%. This is due to the effect"tax shield of credit financing". Suppose the interest rate on the loan is 15%, as in the previous example. Then the actual cost of the loan is 15%(1-tax rate in percent). The latter in our example is 25%. In this case, the company's loan will cost 11.25%. WACC takes this into account.

Factors

Let's look at what affects WACC. This is an indicator that characterizes the required profitability of an investment project. And it is influenced by such external factors as the situation in the stock market, the interest on risk-free capital investments and the base rate of the market, as well as income tax. The company has to work with them, trying to most successfully use the resources it has in the current situation. Important factors for management are such factors as the beta coefficient, the risk premium established by the enterprise, the ratio of debt to total capital and credit rating. The following calculated indicators also affect the weighted average cost of capital:

• Interest rate, cost and leverage.
• Security market risk premium.
• Value and equity share.

Formula

First, let's introduce some symbols. Among them:

• E is the cost of equity.
• RE is its required return.
• D – cost of credit funds.
• RD - Interest on the loan.
• TR is the tax rate.

So WACC=(ERE)/(E+D) + (DRD(1-TR))/(E+D). It should be noted that this formula takes into account only one type of loan financing. If our firm uses several, then all of them must be substituted separately with the appropriate rates.

Basic Fundraising Principles

Companies benefit from financing from credit resources if the interest on the use of the latter is low, since this reduces the company's weighted average cost of capital. However, the goal of any bank is not charity at all, but a profitable deal. Therefore, more stable companies that have substantial collateral receive lower rates for borrowing. Banks strive to get as complete a picture of their borrower as possible, the qualifications of its top managers and staff, the company's track record and its business plan.

Criticism

WACC is a universally recognized tool for assessing the required return on investment projects. However, it has a number of significant problems:

• Having a "credit financing tax shield". At first glance, it seems that the more loans, the better. And it really reflects the WACC. But how to take into account the increasing riskiness of projects with an increase in their financing at the expense of creditors' money?
• Beta problem. This indicator should reflect the riskiness compared to the volatility of the assets of the entire market. Most often used by companies fromlist of the S&P 500. However, many financiers will disagree with the fact that volatility is the same as risk. And this does not take into account WACC at all.